Definition of MACD? All you need to know about moving average in stock trading

The MACD indicator allows traders to determine the current trend and forecast the direction in which the prices are likely to move. Traders, using this indicator, can determine the rate of change in prices.

The Moving Average Convergence-Divergence indicator, or MACD, is a trend indicator that shows the relationship between two moving averages of security's price during a bullish or bearish market. It can be used to signal entry or exit opportunities in a particular stock. 

The MACD line is determined by subtracting the 26-period exponential moving averages (EMAs) from the 12-period EMA. 

MACD works best with daily periods— typically 26, 12, and 9 days.

What is MACD?

Created by Gerald Appel during the 1970s, the MACD indicator defines momentum and its directional resilience by computing the difference between two-time intervals, which are a compilation of historical time series. It uses moving averages of two different time intervals – usually historical closing prices of securities— and a momentum oscillator line is calculated by deducting the two moving averages, also known as 'divergence.'

The two moving averages are chosen using exponential moving averages (EMA) based on the criteria that one should have a shorter period than the other.

Plotted on top of the MACD line or zero line, the nine-day EMA, also referred to as the signal line, serves as a trigger for ‘buy’ or ‘sell’ signals.

Traders may buy the security when the MACD line crosses above the signal line, and sell it in case the MACD line remains below the signal line.

Instead of crossing the signal line, when the MACD line remains at the zero level and gets positive, it indicates a bullish trend. The MACD indicates a bearish trend when it crosses the zero line in the downward direction and becomes negative.

The MACD indicator allows traders to determine the current trend and forecast the direction in which the prices are likely to move. Traders, using this indicator, can determine the rate of change in prices.

The MACD indicator appears on the price chart as an oscillator with two moving averages. However, unlike other oscillators, it lacks boundaries. It is completed with an MACD histogram that overlays the two moving averages.

MACD indicators are usually interpreted using crossovers, divergences, and rapid rise/fall methods. 

How to read MACD on a graph?

The MACD indicator includes three components: MACD line, signal line and MACD histogram. Let’s take a look at these three components: 

1. MACD Line (short-term EMA) , represented typically in blue, is calculated by subtracting a short-term 12-day EMA from a long-term EMA, which is generally 26 days. 

Line MACD = (26-day EMA) - (12-day EMA)

2. Signal Line (long-term EMA), typically represented in red, is a 9-day average of the closing prices. 
3. MACD histogram is the difference between the MACD line and the signal line. It is positive when MACD is over the signal line and negative when the indicator is below it.

A positive MACD or a higher histogram is an indicator of building momentum. In such cases, the stock's price rises. Similarly, when the MACD and histogram values fall, it indicates that the price is likely to go down and any holding should be cleared by selling.

However, MACD has its own set of limitations. One key limitation of this method is that it often signals a possible reversal while there may not be any such reversals.

Since MACD is based on EMA, focused on more recent data, it may react actively to the direction of change in current prices. Traders also take into account other signals, including RSI, along with MACD for confirmation.

In conclusion 

MACD could be an effective tool for the traders who rely more on the technical analysis of share price movement depending on moving-average and daily data. As MACD is based on exponential moving averages, it relies on the most recent data and could help the traders to get an indication about the changes of direction in the current price movement.